Now here is a presentation by Jesse Bricker, Jacob Krimmel, and Claudia Sahm of the FRB, using survey expectations data to explain the housing bubble. Pretty neat stuff.

The question is why asset price crashes affect the real economy. One possibility is that they precipitate a regime shift in household savings behavior, causing households to abruptly start focusing on "balance sheet repair", also known as "deleveraging". There is some evidence that this kind of thing does in fact happen; the question is why. One possibility is that asset price crashes shift people's economic expectations.

If people have extrapolative expectations, then rising asset prices can be a signal of rising fundamentals, which people may mistake for a long-lived, structural trend. If asset prices then crash, people may then make the similar mistake in the opposite direction, forecasting a long-term continuing slump. Note that this explanation is my interpretation, not that of Bricker, Kimmel and Sahm, though they seem to be after something similar.

Anyway, BKS look at survey data on economic expectations, from the Survey of Consumer Finances. Those surveys are pretty accurate on a lot of measures - expectations generally end up matching aggregates, such as income growth. So BKS assume that they're accurate for measuring expectations as well.

What BKS find is that people who had more positive expectations increased their spending more - in other words, the expectations people reported in surveys correlated with the actions they actually took. Here is a graph from their presentation:

Interestingly, the expectations-based spending gap was bigger in 2003 than usual, and biggest in 2006, offering hope that this kind of data can be of use as a bubble detection method in the future. Consistent with this, they also find that survey-based income growth expectations predicted the ZIP codes in which housing prices would rise (and then crash) the most:

BKS find that households with more positive expectations spent more in response to rising house prices before the crash...but not after. That's an interesting discrepancy that might cast doubt on the idea that irrationally pessimistic expectations are the cause of deleveraging.

Anyway, this is one more interesting piece of research investigating the possibility of irrational expectations having major macroeconomic effects. It's not a slam-dunk case that extrapolative expectations cause bubbles, and I'd like to see a lot more investigation of extrapolative expectations as a cause of deleveraging. But it certainly seems to confirm that survey expectations measures are measuring something real and important and predictive. If I were a hedge fund, I'd want to get my hands on some SCF-type expectations data. And in the future, this offers some promise that irrational-expectations models may augment our understanding of financial business cycles.

53 comments:

Science has long had problems with self-reports and their overuse:http://blogs.discovermagazine.com/neuroskeptic/2012/08/29/beyond-self-report/I would not like to see this overuse spread to economics."The question is why asset price crashes affect the real economy."-'Cause they contradict people's plans for the future, causing re-allocation of resources. What, exactly, is the issue here? This is exactly the sort of problem laymen don't understand why economists are still arguing over.

"This is one of your more stupid remarks, pithcom, not that you have not handed out plenty here already."

And this is a completely unhelpful response.

If the only way in which asset price crashes affect the real economy is by way of NGDP, and if we know how to stabilize NGDP in the face of asset price crashes, then we shouldn't allow such crashes to trigger recessions. If they do, that is a failure of demand management, not a failure of asset market regulation, etc.

Notably, the 1987 crash had apparently no effect on the real economy, and NGDP cruised right through it. This suggests that we do know how to contain such crashes. By the way Barkley, this is basicallyBen Bernanke's view, too, so I guess you think he's pretty stupid too.

The 2000-3 stock market crash was almost as large as that during the Great Depression.I don't trust anything Rosser says any more since his baseless and insult-filled tirades against me on the last post and the post before the last.

Without listing all of it, I shall simply note that literature on how surveys of expectations do much better than ratex have been around since the late 70s and 80s, particularly in regard to forex markets. Of course this stuff got more widely ignored because it was not coming from Big Name people like Woodford and Shleifer, with the former chewing the ratex cud in his own way back the, while Shleifer was more behaviorally oriented, but not yet buying into survey data, which has long been reviled by much of the economics establishment. But, it looks like that might be about to change.

Thanks, Noah for drawing attention to... and asking good questions about ... our research. It is preliminary and our first goal was simply to show survey expectations help us understand cyclical behavior, the hows and whys are future work.

One comment: just because the income expectations in the two areas converge after the correction in house prices and the Great Recession does not mean everyone's expectations got back to fundamentals (rational expectations). See the slide "Expectations Unusually Pessimistic in the Recovery" and I have other work that shows broad-based pessimism after the recession: http://www.federalreserve.gov/econresdata/notes/feds-notes/2013/why-have-americans-income-expectations-declined-so-sharply-20130926.html

Lots more work to do, thanks for the push.

PS And Barkley is right it is not a new idea that subjective expectations can differ from rational expectations in ways that matter for the macroeconomy. There's always a literature, happy to be adding to this one.

I agree wealth effects and deleveraging are broad terms. Here's a bit more on unpacking deleveraging (and likely include expectations): http://www.federalreserve.gov/econresdata/notes/feds-notes/2014/deleveraging-is-it-over-and-what-was-it-20140624.html

"That's an interesting discrepancy that might cast doubt on the idea that irrationally pessimistic expectations are the cause of deleveraging."

Who's to say what is rational and what is not rational? And even if it can be fairly considered irrational behaviour in the everyday sense of the word, why is it extraordinary the point it has to be questioned? I would bet if you had seen your neighbours lose their homes, major banks collapse and the world in turmoil you would be taking the most conservative action you could. This is why the adherents to the RE doctrine don't get it. It is real people who make decisions about their behaviour in economic situations. People's behaviour cannot be abstracted and homogenised, as much as mathematicians try. Isn't 40 years of this nonsense enough?

"And in the future, this offers some promise that irrational-expectations models may augment our understanding of financial business cycles."

Here we go again. Who says it's "irrational"? Why not just call it "behaviour" or "expectations"? I can understand mathematicians not being able to deal with behaviour that might be seen as irrational. Their intellectual worlds are constructed around abstract, formalised, logical structures.

Our argument was not about rationality in a general sense ... the argument is that subjective expectations (or even subjective beliefs about what just hapoened) are not necessarily the same as ex post realizations. It doesn't mean people are wrong just that you can't use objective outcomes to fully understand their behavior.

The problem is that the language mathematicians use is used in such a manner as to confer on their analyses a semblance of a foundation in science and objectivity. It just doesn't work. The more abstract, the more unreal. May as well be reading Alice in Wonderland.

Henry: "The problem is that the language mathematicians use is used in such a manner as to confer on their analyses a semblance of a foundation in science and objectivity. It just doesn't work. The more abstract, the more unreal. May as well be reading Alice in Wonderland."

The people who do economics these days are trained essentially as mathematicians. Nowadays economic insight in economics is virtually absent. RE was an abstraction formulated by diverted engineers and econometricians and mathematicians.

I see Henry has taken up the mantle of such noted crackpots as John D, Greg Ransom, Robert Vienneau, and Richard Serlin in making unsubstantiated assertions on the Internet. Good for you, Henry, you'll really show them now! Your internet outrage is unbounded and powerful!

Here I think you'd be better off describing what you call "rational expectations" as "model-consistent." There's nothing about getting a wide variety of responses that suggests irrationality, and nothing about getting a median response different from a modeled expectation that suggests irrationality. What's irrational is arrogating to know what is rational from everybody else's perspective. So yes, more surveys less dogma please.

A bit more on the subject of how economists misuse the word "rational."

Noah, I know that placing economics within the realm of science is important to you, and it's important to most economists. So why does there seem to be such a widespread acceptance within economics of hokey, totally unscientific psychology?

In the most generous interpretation, the words "rational" and "irrational" are given totally different meanings in economics than in psychology or everyday use. In the least generous, when economists speak of "rational" and "irrational" they're revealing deep ignorance of how human decision-making processes work.

Let's start with how economists typically explain bubbles: as manifestations of "irrational" optimism and "animal spirits." After all, it's usually easy to demonstrate that it would have been mathematically impossible for the bubble to continue indefinitely. So the people who bet it would continue must have been betting emotionally and irrationally, the logic goes.

But anybody involved in bubble buying can tell you it doesn't work like that. They usually understand the bubble can't continue forever. And if they don't, that's ignorance, not irrationality. Buyers are not much more emotional during bubbles than they are during other times. They're usually slow and calculating. They rationally decide, based on limited understanding of complex systems, that the bubble will carry on for long enough to make their purchase worthwhile. And very often they're right.

What economists mean when they say "irrational" is: I have decided, based on my theory, that there is only one correct course of action in such and such a scenario, and anybody who doesn't take that course of action therefore is "irrational." That is not science. It's not even in the ballpark of science.

Sorry, but you are wrong on several points. The most important one is that indeed there is a lot of evidence that during bubbles some investors do become more emotional, with this curiously sometimes happening most dramatically with professional investors of all people. Kindleberger was right to title his famous book, Manias, Panics, and Crashes, a book that the late Paul Samuelson declared was the one must book that anybody interested in investing must read.

Now, as for this matter or rational bubbles, there are two ways around this (and you clearly are ignorant of the theoretical lit on bubbles, sorry). One involves overlapping generations as Jean Tirole showed 30 years ago.

The other is to allow for stochastically crashing bubbles, where the probability of crash increases as the bubble moves farther away from the fundamental. In that case, the price must accelerate upwards at an ever-increasing rate to provide a risk premium for the inevitable crash, at least for a risk-neutral or risk-averse rational agent. Olivier Blanchard developed this model over 30 years ago, and some price series have followed this pattern, although most apparent bubble ones do not accelerate sufficiently. They are probably driven by the sorts of irrationality you dismiss.

"Buyers are not much more emotional during bubbles than they are during other times. They're usually slow and calculating."

Absolutely totally disagree. Have you ever noticed that when markets reach a major inflection point that volumes increase massively. What this says is that when markets are turning there is widespread disagreement. Buyers have one opinion and sellers have the contrary opinion. Either one or the other of them is bound to be wrong. So which group is being rational (in the every day sense of the word)? Look at the lemming like behaviour in the recent bust in Chinese equity markets. Millions of new trading accounts were opened in the last few months by neophyte traders. And they say no-one rings a bell at the top. Sit around a dealing desk in a broker's office when markets are running hot and you will see human behaviour at its most venal and atavistic. It could be fairly said that if one wants to understand the behaviour of markets one might best seek to understand the aetiology of animal herding. I would not imagine mathematicians are adequately equipped to do the same.

How can any model which attempts to characterise this behaviour in a formal manner ever be able to use the notion of an independent representative agent? What are the "model consistent" expectations for a market behaving as described in the previous paragraph?

You guys are missing my point completely, and showing sadly that the least generous interpretation I mentioned is likely correct.

I was working on the buy side in 2008 and as a trader in 2011, so I know panics very well. A "madness of a crowd", literally understood, as in a panic, certainly has more than the usual irrationality about it, though most of the selling is entirely rational. Bubbles do not develop through sudden manic crowd behavior.

A popular delusion is not irrationality. To be deluded is to perceive the facts wrongly.

I'm not at all "dismissing" irrationality. What I'm dismissing is that a person can assert that in situation X behavior Y is rational and all other behaviors are irrational, and earn the designation of scientist.

On the contrary, he has set himself against everything the science of psychology knows. No person is every entirely rational or irrational. Nobody has a perfect understanding of any situation and nobody can predict the future. Everyone applies a mix of deduction, reason and emotion to every decision.

I'm just telling the very basic basics of psychology. To go against it is about as scientific as denying evolution.

When I said buyers are not much more emotional during bubbles than at other times, that's what I meant. I'm allowing that they could be on average somewhat more driven by emotion. But to construct a theory of bubbles developing from an emotional factor alone is just plain silly.

The growth of a bubble is a long, drawn out process. It is nothing like a sudden panic. During bubbles, the tendency to extrapolate the past into the future may seem more foolish than it does at other times. But people always extrapolate from the past. Extrapolation of the past is quintessentially rational. Another name for it is learning from experience. There's nothing irrational about having an imperfect understanding. Everyone has an imperfect understanding, including the guy who models a situation and declares decision X to be the one and only rational decision.

After a fiscal loosening, is it the obviously correct response to start saving, to prepare for an inevitable consolidation? No. Actually almost nobody does that. To assert that they do just because your personal opinion happens to be that they should is not science.

So again, yes, please, more surveys, less dingleberries professing to know how everybody thinks without asking them.

Oh gag, Tom. Yes, we have seen you declare yourself to be a brilliant genius who knows more than others. Sorry, there are people here who know much more about psychology than you do, and it looks to me that you basically do not know the literature on bubbles. I would suggest you cool it with your foolish chatter about dingleberries. You are on your face with anecdotes rather than scientific evidence. You seriously do not know what you are talking about, even if you did trading in 2008 and 2011.

Thanks, Tom. Your points regarding the meaning of “rational” are obviously true, but judging by the reactions, the obvious apparently needs to be stated.

Speaking of psychology, the history of Skinner’s “behaviorism” makes a nice counterpoint. In that intellectual bubble, supposed scientists got themselves into a methodological snarl that led them to deny the idea of thinking itself -- the very opposite of believing in a near god-like rationality. Behaviorism was a bizarre, retrograde episode in the social sciences, on a par with recent macroeconomics, though less destructive. Both were driven by an attempt to avoid confronting the complexity and messiness of actual human thought.

You continue to miss my point completely. I'm not saying I'm a genius or know the science of psychology deeply. I'm saying that the basics of psychology are well-known and that "rational expectations" modeling contradicts the basics of psychology. I'm not commenting on the entirety of the bubble literature. I'm criticizing many economists' misuse of "irrationality" and "animal spirits" to explain development of bubbles. I know both bubbles and panics very well, and I've made only non-controversial statements about them, without a single anecdote. You have repeatedly said I'm wrong, but you haven't contradicted even one single statement I actually wrote. And you've made many off-topic comments that demonstrate that either you misunderstood me or you want to shift the topic. My impression is that you felt insulted on behalf of economists as a group, but for whatever reason you don't want to or are unable to address any of the substance of what I wrote.

I could go on a bit, but here is just one point. You claim that investors do not get more emotional during speculative bubbles. You provided no evidence, just your assertion, although presumably this is drawn on your own anecdotal experience trading. Not good enough. I noted studies showing you were wrong. You made no effort to respond to that, simply asserting that I am missing your point and that you "know both bubbles and panics very well," presumably from your vast experience of trading. Not ood enough, and you are wrong.

So, just one reference, although there are others,

Robert J. Shiller and John Pound, "Survey evidence of diffusion of interest among institutional investors," Journal of Economic Behavior and Organization,1989, 12, 47-66. They were studying behavior in the 1987 stock market crash, the largest single day drop ever, and maybe you have never seen emotionalism in markets, but they certainly did, and there are plenty of reports of it from the 1929 crash, even if the tales of people jumping out of windows on Wall Street were exaggerations.

What Tom is criticizing the use of the term "rational expectations" by economists. I do not think he knows how the term is used. Telling us here that psychologists have more complicated views about what constitutes rationality or that what may look like irrationality is really ignorance is not a revelation. Rational expectations actually has nothing to say whatsoever about the internal states of mind of people. It simply says that on average they accurately forecast the future, keeping in mind that this may mean that they never actually succeed in accurately forecasting the future.

While it is true that some bubbles do not end in crashes and some sudden falls in price reflect sudden changes in fundamentals, the crashes I was talking about (1987 and 1929) most certainly came at the end of bubbles.

OK, I shall grant that Tom did allow for the possibility of some higher rate of emotionalism during bubbles, but his claim that nobody could develop a theory of bubbles based on such irrationality is simply wrong, although I grant that these are not formal mathematical theories. He should read Kindleberger and Minsky in particular, as I have already suggested. They present it, and one of the most mathematically sophisticated of students of bubbles (and also an emormously successful trader as we have learned since his death) Paul Samuelson thinks Kindleberger beats everybody on how to think about bubbles.

BTW, both Minsky and Kindleberger simply eschewed the language of "rationality" versus "irrationality" in either its simple-minded ratex form or in some fancier psychological form. They did assume that people trade to a substantial degree on their emotional states, and that such states can contagiously pervade entire markets, and that indeed there is a natural progression of those states over time in markets subject to speculation, which they laid out.

This was the old argument by Milton Friedman as to why floating exchange rates would be more stable than fixed ones, something that has not proven to be true.

There were a series of papers published in several leading journals back in the early 80s by DeLong, Shleifer, Summers, and Waldman that laid out how a "noise trader" could do better than a "rational expectations investor." Basically it boils down to some people really do know how to chase a bubble and get out at its peak. Many will be driven out, but some will end up as the richest guys on the block, e.g. Bernard Baruch and Joseph P. Kennedy back in 1929 (the old story on Baruch was that he sold all his stocks when his shoeshine boy started giving him stock tips).

Before 2008 people invested rather than saved because investing paid profits. After 2008 investing paid considerably less profits and thus saving became more profitable (either in the form of actual bank deposits of some sort or paying down debt).

"early 90s" not "early 80s" Such papers would have been unpublishable in leading journals in the early 80s prior to the 87 crash and prior to Fischer Blackj's "Noise" speech to the AFA in 1986, when ratex was riding at its intellectual highest.

The problem with the criticism of ratex is treating it as a behavioral description as opposed to parsimonious specification of the problem. Replacing ratex with random behavioral patterns will give you much curve fitting pleasure with little information.